by Mark Weisbrot People's Weekly World Entered into the database on Friday, July 14th, 2006 @ 18:01:56 MST

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Fed fights inflation by increasing unemployment and lowering wages

Everyone recognizes that the U.S. economy is slowing, but the question is,
how bad will it get? One disturbing sign is that the Federal Reserve is raising
interest rates as the economy slows, and it is not clear when it will stop.
This is not good because each rate hike is deliberately designed to slow the
economy by causing both consumers and businesses to borrow and therefore buy
less. The idea, as Fed economists see it, is that as overall spending is reduced,
employers will hire fewer workers. As unemployment rises, employees are in a
weaker bargaining position, and this leads to slower wage growth. Slower wage
growth, the Fed hopes, will lower inflation.

Although it is no secret among economists, most Americans don’t know
that the Fed fights inflation by increasing unemployment and thereby lowering
wages. The public probably would find this unsettling. Inflation, as measured
by the Consumer Price Index, has been running at 5.7 percent over the last three
months, up from 4.2 percent over the previous year. But most of this is the
result of higher energy prices and the fall of the U.S. dollar against other
currencies, which raises the price of imports and therefore adds to inflation.

‘Banker’s-eye view’ of the economy‘

The Fed sees rising wages as the problem, because the people who run the Fed
do not look at the economy from the point of view of wage and salary earners.
They have a “banker’s-eye view” of the economy, which sees
even a relatively small increase in inflation as a dangerous thing because it
erodes the value of bonds. And for them, the way to keep inflation in check
— no matter what its cause — is to keep wages from rising.

Average wages, adjusted for inflation, are less than they were four years ago
— which is unfair, to say the least, given the economic growth over this
period.

But it’s about to get worse. Since the mid-1990s, the country has accumulated
an enormous housing bubble as house prices nationally have risen nearly 70 percent
after adjusting for inflation. In some bubble areas, mostly the East and West
Coast, the real increase has been over 100 percent. Since house prices have
historically increased at about the same rate as inflation, this means that
more than $5 trillion of excess paper wealth — similar to the stock market
bubble of the late 1990s — has been created. Just as bursting of the stock
market bubble caused a recession in 2001, the collapse of the housing bubble
will almost certainly do so.

‘Home sales and prices, both down‘

There is evidence that this bubble is already beginning to burst: new home
sales, existing home sales, and the median price of existing homes were all
lower in the first quarter of this year as compared to peaks last year. Vacancy
rates for new homes are rising.

House prices do not have to collapse at once in order to tip the economy into
recession. Many Americans use their houses as an ATM machine, borrowing against
the value of their homes. These home equity loans, including hundreds of billions
of dollars “cashed out” when people refinanced their homes as mortgage
rates hit record lows in recent years, are what has driven the U.S. economic
recovery since 2001. Falling home prices leave less equity that homeowners can
borrow against. The personal savings rate is at a record low for the post-World
War II era, hitting negative 1.6 percent in April.

Rising mortgage interest rates will finish off the housing bubble if oversupply
and a psychological reversal of the speculative mania don’t do it first.
This party is about over, most unfortunately for the majority of Americans who
never got to join in the festivities.

Mark Weisbrot is co-director of the Center for Economic
and Policy Research in Washington. This column was distributed to newspapers
by McClatchy-Tribune News Service, and published in the Charlotte Observer.